In the distressed M&A arena, Bankruptcy Code Section 363 sales are by far the preferred method to complete a transaction. After all, the Bankruptcy Code provides would-be purchasers unmatched protection with its promise that such sales are “free and clear” of all liens, claims and encumbrances. Right? A recent decision from the U.S. Court of Appeals for the Third Circuit in the high-profile Revel AC bankruptcy case, however, serves as a warning that reliance on the typical “free and clear” language in a sale order is not always a safe bet, see IDEA Boardwalk v. Revel Entertainment Group (In re Revel AC ), Case No. 17-3607 (3d Cir. Sept. 26, 2018).

The Revel AC bankruptcy culminated in the sale of a $2.5 billion dollar casino project to development company Polo North Country Club, Inc. for an infamously low price. As is typical of bankruptcy sales executed pursuant to Section 363 of the Bankruptcy Code, Polo North acquired the Revel property free and clear of all liens, claims, encumbrances and other interests of any kind. The purchase agreement underlying the sale, however, did carve out certain exceptions. Under the terms of the sale, Polo North stepped into the debtor's shoes as landlord of certain nightclubs and restaurants within the casino. Importantly, the purchase agreement expressly preserved certain tenant rights, including setoff and recoupment as well as the right to enforce the provisions of Section 363(h) of the Bankruptcy Code—which, in relevant part here, permitted tenants to enjoy the same rental terms as originally set forth in its lease. IDEA Boardwalk, the operator of certain entertainment venues within the casino, was a tenant whose lease remained in effect with Polo North post-sale and elected to enforce its Section 363(h) rights.

IDEA's lease was complex—described by the Bankruptcy Court below as a “bloated morass”—and involved the interplay of capital contributions, revenue-based rent calculations and recoupment rights in favor of IDEA under certain circumstances. From a high level, the lease required the landlord to make certain capital contributions to the venues and provided IDEA the option (but not the obligation) to contribute to capital investment as well. Rent obligations were calculated based on each party's percentage of capital investment and the revenue that each venue brought in. Finally, under certain conditions—namely, when venue revenue overcame a certain threshold, but return on capital investment was negative—IDEA was permitted to exercise recoupment rights against the landlord.  By the time that Polo North had stepped into the debtor's shoes as landlord, the poor performance of the venues and of the casino overall, entitled IDEA to reduce its rent obligations by exercising those recoupment rights.

Polo North argued before both the Bankruptcy Court and on appeal to the U.S. District Court for the District of New Jersey that, pursuant to the terms of the purchase agreement and the Bankruptcy Court's sale order, it acquired the Revel property and the leases free and clear of any recoupment obligations to IDEA. Both courts disagreed and Polo North appealed to the Third Circuit. To Polo North's dismay, the Third Circuit upheld the lower courts' rulings thus, permitting IDEA to reduce its rent obligations.

Under relatively straightforward reasoning, the Third Circuit easily concluded that the terms of the sale order preserved IDEA's right to recoupment. After all, the sale order explicitly carved out tenants' recoupment rights from the free and clear provisions and expressly permitted tenants to preserve their original rental terms via the Section 363(h) election. IDEA made such an election. The court found that the preserved rental terms of the lease undoubtedly included the recoupment payments because those rights were deeply intertwined with IDEA's ultimate rent obligations. The court reasoned that it would be illogical and unfair to permit only part of the lease's complex payment mechanism to survive the sale. Thus, the carve out from the sale order's broad “free and clear” language permitted IDEA to reduce its rent obligations via recoupment payments owed from Polo North as landlord.

What is more interesting is that the Third Circuit went out of its way to explicitly rule that even without the carve out in the Sale Order, IDEA was entitled to reduce its rent obligations by way of equitable recoupment notwithstanding any “free and clear” protections. The court explained that a claim for equitable recoupment against a debtor requires that a creditor's recoupment claim arise from the same transaction or cause of action as the debtor's claim; this standard is exacting, requiring more than mere common subject matter. Indeed, a claim for equitable recoupment must be such that it would be inequitable for the debtor to enjoy the benefit of a given transaction without also requiring that debtor to be subject to the obligations to the creditor that give rise to the recoupment claim. A claim for equitable recoupment is no small thing—it fundamentally allows an unsecured claimant to avoid the bankruptcy priority scheme by attaching directly to (and reducing) a debtor's claim against a creditor. IDEA successfully argued that the landlord's recoupment obligations under the lease were so intertwined with its own rent payments that it would be inequitable to permit Polo North to enjoy rent payments under the lease without enforcing the larger payment mechanism, including the recoupment amounts due to IDEA. Critically, the court rejected the argument that the bankruptcy sale transaction—which made no carve out for equitable recoupment—was free and clear of any such claims. The court ruled that “the doctrine of equitable recoupment is an affirmative defense, and the sale of assets free and clear of liens, encumbrances, and interests does not include defenses to claims.”

This creates yet another chink in the armor of “free and clear” bankruptcy sales and, to some extent, makes affirmative defenses more valuable (or more viable) than actual standalone claims from a creditor perspective. For one, as the court noted, affirmative defenses skip to the front of the line, despite the Bankruptcy Code's priority scheme; while they may not translate to cash going into creditor accounts directly, they have the same net effect. What is more—and what makes the Third Circuit's ruling in this case particularly interesting—is that as a matter of law, affirmative defenses are immune to even the most iron-clad free and clear language that can be drafted into a purchase agreement or sale order. Perhaps there are solutions that would-be buyers could work into agreements to protect themselves from affirmative defenses (e.g. indemnification provisions, requiring that a debtor cover the cost of any affirmative defenses arising pre-sale). Even so, as courts continue to find more and more exception to the protections provided by Section 363 of the Bankruptcy Code, it becomes more and more obvious—depending on free and clear language is no longer a safe bet.

Practitioners should also take note that in many sale orders, a creditor's right of offset is often sought to be stripped away as part of the “free and clear” language. In the first instance, it would obviously be prudent for a creditor with an offset right to object to such sale order language. However, even if unsuccessful, under the Revel decision, should that offset right rise to the level of recoupment, then the recoupment right could still survive the otherwise claim stripping language.

Francis J. Lawall, a partner in the Philadelphia office of Pepper Hamilton, concentrates his practice on national bankruptcy matters and workouts, including the representation of major energy and health care companies in bankruptcy proceedings and general litigation throughout the United States.

Kenneth A. Listwak is an associate in the corporate restructuring and bankruptcy practice group in the firm's Wilmington office.